The Hope Premium

It is a strange fact that for many professions, the odds of success are extremely low, and so is the average pay. For example, many people have dreams about getting into acting, but I’ve seen estimates that only 5% of people who call themselves actors make a living acting, as opposed waiting tables and whatnot. Similar odds exist for would-be novelists, musicians. There are the high profile people one thinks of for the categories that act like lotto jackpots, a focal point that overwhelms objective odds. It is somewhat unrealistic, if not cruel, to tell people that chasing their dreams is a waste of time. People like to dream, and after all, ‘the experts’ are often wrong. Yet I think this phenomenon suggests that perhaps people accept low average ‘return’, in exchange for the dreams these professions present.

The inequality in these fields, where incomes have a power law distribution, is not bug, it’s a feature. The presence of superstars, whose income and status is so high, is the offsetting basis of the dreams for those in the industry, why they are willing to accept less ‘on average’. In dreams without such opportunities, you need security, or some other offset to compensate. If this is true, it suggests there is a general hope premium in industries, and even assets. Many financial assets that have the highest volatilities have below average returns, if not negative returns: out-of-the-money call options, Junk bonds, highly volatile stocks, extreme-odds at the racetrack. We pay to dream, and it can be frivolous, as with the $1 I recently spent on a $206MM lotto ticket Saturday (odds: 1 in 130 million, I did not win), but it can also be a significant part of one’s investment portfolio (not wise, in my opinion, but real).

People take risk based on hope, and hope is a function of one’s dreams. In 1961 Walter Gutman wrote a book You only have to get rich once, and noted that "growth stocks might better be called dream stocks", and that ‘dreams are real–we have them every day. It’s a big mistake to think dreams are unreal and what is called real life is real’. This is a simple, profound, model of the value effect, where stodgy, low beta firms without much upside generate a higher return than stocks that can be classified by some as the next ‘Yahoo!’ Dreams, in moderation of course, are paradoxically as real as anything, and assets that embolden dreams have extra value for investors, and they are willing to accept a lower ‘average’ return because in taking risk, because they are already ignoring the skepticism of the consensus.

Jonathan Alter recently wrote that we should perhaps pay teachers more, and pay their superstars a lot. I think the data suggest that if we start paying really large salaries for superstar teachers, we could pay a few of them more, but pay them in aggregate less. That is, we would have just as much supply if we offered them the hope of become very wealthy, with a lower average pay, than our current system, which pays them a rather solid pay but with very limited upside. No one with really large ambitions goes into education precisely because they top has a low ceiling. Hope is worth something, in terms of a higher price, and thus lower return.

In some of those professions, I think you run into the trouble of calculating utility. Being a Hollywood star obviously provides more rewards than the money alone. The same goes with being a rock star, and I guess an author as well, though to a lesser extent. There is also the utility of males signaling themselves as “risk takers” in certain situations, which I think Robin is often pointing out.

People misjudge their chances (1) because they are constantly encouraged to both by their friends and by the media, both of whom win their favour by telling them what they want to hear, (2) because of availability bias.

Stuart Armstrong

This would also explain the lack of people going into plumbing and other manual professions, despite the higher pay available.

But hope can’t just survive on the possibility for some of making big bucks and fame. Lots of people have to truly believe that they can make it to the top; hence success has to be somewhat random. Rocket scientists are high status and high pay, but don’t attract the crowds of eager recruits that acting does. A lot of wannabe actors see an Oscar winner and moan “that coulda been me!”, because, in fact, it could have been.

The fact that sucess in somewhat random is a feature, nto a bug, of an industry with a high hope premium.

It’s a big mistake to think dreams are unreal and what is called real life is real.

Um…

js

interesting idea but acting is a voting machine based system. you get paid more because people like you. its a tangible and irrefutable way to measure rewards given to those who are “better” actors/stars. the line between star and non-star is distinct. teaching should be a weight based system where you are rewarded based upon how well you teach. you can make the argument that the market prices the avg actor’s salary correctly because an actor that does not act returns little to the system. the actor sees and understands this and is ok with producing little and receiving little pay believing that someday he might hit the jackpot.

creating this incentive structure for teaching would not obtain workers you would want for a functioning educational system. they provide value that they should be compensated for directly otherwise they will become dissatisfied and leave. raising avg wages and developing a system that rewards results would be a better solution. i think there is a link between ambition and reward, but the solution is to pay them all more if we want more out of them.

lol at Eli — I was thinking while reading this post that Eli would have an aneurysm when he did. Dreams! Real! DOES NOT COMPUTE!

eric falkenstein

Ken, Eli: I think the Gutman ‘dreams are real’ assertion relates to the fact that a significant portion of our day is in dreaming: at night (obviously), watching TV or reading books, thinking about a future that does not exist. To merely ‘live in the moment’, on flow, is what a non self-aware organism does. Now, to plan rationally for some feasible objective might be considered on the cusp, ‘good’ dreaming. But I think many of us who love the theater or sci-fi books that take us to far off lands, think their access to dreams is part of what makes them human and happy–even though it has zero affect on helping the achieve goals that change physical reality.

Now, I think this is often overdone in many parts of our lives, and one should definitely not dream with significant portions of their portfolio. But I also think many people actually do invest this way, because there’s no other explanation for why people choose to invest in asset classes with demonstrably lower Sharpe ratios, other than the explanation of ‘overconfidence’: the average return is -x, but there’s a chance you are well above-average.

In Dante’s Inferno, at the Gates of Hell it says “Abandon All Hope Ye Who Enter Here”. He might as well said, abandon your dreams. Such a life is Hell for most people.

zzz

Many financial assets that have the highest volatilities have below average returns, if not negative returns: out-of-the-money call options, Junk bonds, highly volatile stocks …

Is this really true with respect to financial assets (ref.)? Most of these seem to be fairly uncorrelated with the market, so any below-avg. returns could be arbitraged away by holding a well-diversified short position. Good thing you didn’t list credit-default swaps and “toxic” mortgage tranches, though.

It’s a big mistake to think dreams are unreal and what is called real life is real.

This is absolutely correct. Much of what is recognized to be ‘reality’, and called such, isn’t real at all. And dreams are most certainly real things.

Babi

It’s kind of funny to write this comment while a famous actor sits at the table across from mine in a restaurant. He is one of the the hottest new TV stars but looks pretty plain in person… I believe that people often choose careers and investments that have below average returns because those actions require less training and mental effort. Sure, there are highly trained actors, such as myself, but there are also those who have won academy awards without ever being in an acting class. The same goes for investing – it is much easier for the average investor to pick the hot stock than to try to understand the market and make more rational decisions. I’ve been reading ob for a while but this is my first time commenting, so pleeeese be gentle. I’m not a rocket scientist, physicist, or mathematician, just a humble and curious artist.

Jonathan Alter recently wrote that we should perhaps pay teachers more, and pay their superstars a lot. I think the data suggest that if we start paying really large salaries for superstar teachers, we could pay a few of them more, but pay them in aggregate less. That is, we would have just as much supply if we offered them the hope of become very wealthy, with a lower average pay, than our current system, which pays them a rather solid pay but with very limited upside. No one with really large ambitions goes into education precisely because they top has a low ceiling. Hope is worth something, in terms of a higher price, and thus lower return.

This only works if you can amortize the high salary of the superstars over a large base of subscribers. This works with movie actors, musicians and sports stars, but not terribly well with teachers, no matter the success of the University of Phoenix.

BTW, Paul Newman made $100,000,000/yr on his salad dressings. Superstar businessmen make more money than superstar actors. So by this logic, why don’t we see more poor businessmen working day jobs as waiters while they struggle with their low-paying business careers?

Doug S.

There’s another thing to consider:

Performing is fun. Plenty of actors, musicians, writers, etc. “work” for literally nothing, simply because they like doing it.

HH

“It’s a big mistake to think dreams are unreal and what is called real life is real.”

Am I reading this correctly? I think it’s trying to say [poorly] that utility derived from dreams is no less real than utility derived from material things. That is, if you’re happy hoping to become a superstar, you’re not fundamentally differently happy from someone who’s happy with a lot of money and stuff. In essence, it’s basic economics: your utility from being and actor/waiter is the sum of salary+(job satisfaction)+(utility of hope). Whatever you lose on the first one you may get on the latter two, as compared to someone who has a higher salary but has little hope at superstardom.

michael e sullivan

Performing is fun. Plenty of actors, musicians, writers, etc. “work” for literally nothing, simply because they like doing it.

I think this is crucial. A lot of people feel very successful just to be making a living at all in their field. total Utility is greater than making 3-4x as much money doing something else.

Also, to make a living at all, you have to be significantly better than the top tier of amateurs in some way, to some audience. Sometimes it’s just about being significantly better at finding and satisfying a market. I know a lot of amateur and professional musicians. Many of the professionals aren’t necessarily better *musicians* in the fine art sense. But they are entertainers as much as musicians and are much better at giving the audience what they want than most amateur musicians.

So by this logic, why don’t we see more poor businessmen working day jobs as waiters while they struggle with their low-paying business careers?

It’s about status, not money. Businessmen are thought very poorly of, and they’re seen relatively infrequently in the media. Actors are idolized, and most people are very familiar with them.

Why do you think young children want to be firefighters and astronauts, and not investment bankers or accountants?

Roland

The same is true for going to college nowadays. If you sum up how much it is going to cost you, including opportunity cost, it’s simply not worth it. So why is everyone still doing it? I think it’s a problem of cached thoughts.

This seems like a dumb conflation of vehicle and content. Obviously people do dream (who ever made the “mistake” of denying this?), and just as obviously what they dream about is a merely hypothetical (i.e. non-real) state of affairs.

Doug S.

“The same is true for going to college nowadays. If you sum up how much it is going to cost you, including opportunity cost, it’s simply not worth it. So why is everyone still doing it?”

Really? Not having a college degree will still get your resume immediately put into the circular file of almost all HR departments – and well-paying jobs that don’t require a degree generally have their own training period. (You have to train as an apprentice before you can work as a plumber, for example.) According to my parents, at least, college degrees do tend to pay for themselves in the long run.

Doug S.

“Why do you think young children want to be firefighters and astronauts, and not investment bankers or accountants?”

My brother wanted to be an investment banker.

And, as of a few weeks ago, he succeeded, becoming an employee of Goldman Sachs.

Of course, this really isn’t the best time to go into investment banking…

This is a blog on why we believe and do what we do, why we pretend otherwise, how we might do better, and what our descendants might do, if they don't all die.